CLOs Wrap Up Record Year

The U.S. CLO market is now the largest securitized credit sector in the country at $850 billion outstanding, according to Bank of America Corp. That puts it ahead of other forms of packaged debt known as asset-backed securities—including auto loans, credit-card balances and student loans.

CLOs have been one of the top performing credit assets this year, attracting investors in search of higher fixed-income yields in a world of near-zero interest rates. Improving corporate earnings have helped keep default rates low in the underlying leveraged loans, which private-equity firms use to finance corporate buyouts, analysts said. CLOs are the biggest buyers of such loans.

One factor driving sales in the fourth quarter was the year-end transition away from the London interbank offering rate, the scandal-marred interest-rate benchmark that underpins CLOs and trillions of dollars of other financial contracts. Starting Jan. 1, banks won’t be able to issue new debt tied to Libor, while outstanding debt will have until 2023 to transition to a new rate.

Higher-than-expected inflation has also made CLO securities attractive to investors this past year. The securities typically offer payments that rise and fall with interest rates, unlike the fixed payments on many bonds, increasing the debt’s appeal at a time when many investors expect rates to climb. 

Triple-A rated CLO securities have returned 1.4% to investors this year through November, counting interest payments and price changes, according to Bank of America, beating total returns of minus 1.82% from U.S. Treasurys and minus 0.96% from investment-grade corporate bonds. These securities are typically bought by banks and insurance companies. 

Double-B rated CLO securities had a total return of 8.9% this year over the same period, surpassing those of 3.51% and 4.53% from similarly rated high-yield bonds and leveraged loans, respectively. 

Some analysts say that the transition away from Libor could slow the pace of CLO sales. Banks and lenders have come under pressure from regulators to wind down their own and their clients’ exposure to Libor, which is being phased out after regulators discovered traders at large banks manipulated the rate by submitting false data.

But issuers of leveraged loans and CLOs continued to launch deals using Libor through the end of the year, saying it remained attractive for reasons including favorable rates and familiar behavior, according to executives, lawyers and advisers.

Only a handful have sold securities linked to Wall Street’s preferred Libor replacement, the Secured Overnight Financing Rate, or SOFR.

The transition to SOFR could leave some CLO securities with different benchmarks from the loans in their collateral pool, analysts said. Loans sold before the year-end deadline can continue to reference Libor through 2023. That makes it harder for investors to protect holdings against fluctuations in rates and underlying loan price, a phenomenon known as basis risk.  

Until that 2023 deadline, CLO managers will likely look to minimize the risk between their assets and financing, preferring to hold more Libor-based loans in legacy CLOs that pay investors tied to Libor and SOFR-based loans in CLOs that reference SOFR. 

After the transition, however, many analysts expect CLO sales to meet strong demand. Bank of America is projecting around $155 billion in new sales next year, while Barclays PLC expects between $135 billion to $145 billion. If either forecast is achieved, that would make 2022 the second highest sales year on record.

“We might have a few slow weeks coming into 2022, but then I’m sure we’ll have deals teed up,” said John Kerschner, head of U.S. securitized products at Janus Henderson. “Issuance will remain robust and there will be more attention paid to this asset class.”

Write to Sebastian Pellejero at [email protected]